An annuity provides a stream of payments made out on a periodic basis – a fixed sum of money paid to somebody annually or monthly, often for the rest of his or her life.
It is a contract issued by an insurer designed to grow funds through an original lump-sum payment or series of payments made by a consumer. The consumer is guaranteed by the lender that they will receive payments periodically or in a future date.
Annuities are one of the main means of securing steady cash flow for a person when they enter retirement. They are products people saved up in their pension pot into a monthly or annual retirement income for them to live on.
Video explanation of what an annuity is
As far as a private pension is concerned, experts say the annuity is an insurance contract that insures the policyholder against living too long. In return for a lump sum, the insurance company (annuity provider) gives the policyholder an annual income for the rest of his or her life.
This is marvelous if the individual lives a long life and can take advantage of the income, but less advantageous if he or she dies early (because they lose their money).
They offer tax-deferred growth of earnings, in addition to sometimes offering a death benefit that will pay a beneficiary a specified amount.
Although tax is deferred on the growth in earnings, when withdrawals are taken from the annuity the gains are taxed at ordinary income rates.
There are three main types of annuities
Fixed annuities – insurance companies pay you a specific rate of interest while the account is growing. Payments are made periodically in a specific amount, which can last for a definite period (such as 20 years) or an indefinite period (for the rest of your life).
Indexed annuities – these are credited with a return based on the performance of a certain index (such as the S&P 500 Composite Stock Price Index). However, the insurance company guarantees that the value of the contract will be no less than a specified minimum, regardless of how badly the index might perform.
Variable annuities – allows a person to choose how to invest their purchase payments, with a wide range of investment options (usually mutual funds). The rate of return and the amount received in payments depends on the performance of the investment options that were picked.